Regulation can be a frightening word. It feels limiting, enforced, undesirable. But it is important to understand if you want to find success in investing. Here’s what you need to know—and why the current system isn’t set up to help you.
More rules don’t help
The UK’s Financial Conduct Authority (FCA) is the principal regulator for financial services. Along with its partner bank regulator, the Prudential Regulatory Authority (PRA), the FCA is mandated to ensure that markets operate fairly.
The FCA website says: “our aim is to regulate in a way that adds the most benefit to those who use financial services. Our Mission explains what we prioritise and why.”
Historically this has been achieved by the use of loosely defined principles but more recently there has been a more systemic move towards more hard and fast rules. The monster document that covers the investment business and which only the compliance department have on their desk is called the Conduct of Business Sourcebook (COBS), also known as the FCA Handbook.
With significant financial implications comes complexity. The FCA is no exception, and the rulebooks get longer and more difficult to keep track of each year.
This matters. As the rules get more complex, fewer and fewer people will be able to make heads or tails of the underlying intent. Meanwhile, those who are minded to partake in skulduggery will find ever more convoluted methods to find loopholes. When rules lack a wider sense of spirit or overarching ethic, there will always be blind spots.
Low interest, low returns, so fee drag matters even more
The aim of regulations is primarily twofold: to engender trust in financial affairs and to ensure that those who act against the common interest are held accountable. Today I suggest that neither is happening.
There are three core assets you can buy when setting up your investment portfolio: cash, bonds and equities. Cash allows you to invest without getting involved with the market. Bonds let you lend capital to a business in exchange for an interest income—ostensibly letting you act as a banker. Equities let you buy shares in a business and (hopefully) earn through their capital growth or a dividend income—you are acting as a business owner.
But none of these are great options in a low interest economy. This matters primarily because savings are the lifeblood of capital markets. In turn, capital markets support businesses which power our economic prosperity. If you want to have a satisfactory pension in later life, then you have to save. Once you’ve saved, you are then better able to invest and get involved in the cycle of prosperity. But with low interest rates, savings don’t accumulate nearly as quickly. This leaves less money for savers to invest. In turn, this leads to less capital being available for promising business. No one wins.
Investors chasing returns and in particular chasing income tend to get ensnared in investment plans that overplay returns and underplay the risks. This is where the FCA needs to alert and protective of retail customers. In essence, they need to protect investors from unintended consequences, whereas their attention has historically been on more literal first-level risk.
There is an old question: “where are all the customer’s yachts?”, which is attributed to Fred Schwed who wrote a book of the same name in 1940. The title came from a story about a visitor in New York more than a century ago. After admiring yachts Wall Street bought with money earned giving financial advice to customers, he wondered where the customers' yachts were. Of course, there were none.
Financial advisers often derive complex investment opportunities simply in order of charge higher fees. The regulator should be monitoring the reasonableness of a fee not just its legality.
The thread running through this is that the FCA should be to protect and serve by ensuring customers—that’s you and me, not some faceless rule—get the best possible outcomes. So far too much of the innovation has been about the yachts and not the customers. We deserve better.
